I am president and chief market strategist of InterMarket Forecasting, Inc., a research and forecasting firm that quantifies market-price signals to guide the asset allocation and trading strategies of pensions, banks, investment managers, and hedge funds. I have authored two books and six chapters on money, banking, economics and public policy. My work has appeared in Forbes, the Wall Street Journal, the Economist, Investor’s Business Daily, Barron’s and the New York Times. I am also a contributing editor at The Objective Standard. I have worked previously for the Bank of New York, Citicorp and H.C. Wainwright Economics. I earned my B.A from Bowdoin College, my M.B.A. from New York University and my Ph.D from Duke University.

6/26/2012 @ 10:51AM9,027 views

Fiscal Austerity and Economic Prosperity

According to Paul Krugman, austerity plans are “self-defeating.” However, the empirical evidence is formidable that when an economy is depressed or weak, the best cure is radically less government spending and taxing, not more. (Photo credit: Wikipedia)

In this third and last of my entries on the “fiscal austerity” debate I discuss how, historically, prosperity has resulted not from the alleged “stimulus” of government deficit spending but from less government spending and big tax cuts. In part two I explained why there’s no magic “multiplier” whereby the economy somehow grows faster if politicians spend our money than if we do, nor by “fiscal austerity” schemes that effectively entail no real cuts in government spending but instead still greater tax burdens on the private sector. When government spending has been slashed materially the economy has performed not worse but far better.

As I explained in part one, moral premises ultimately determine a nation’s fiscal affairs, to the extent they embody prevailing cultural views about the proper purpose, size, and scope of government. Today many people want much bigger government and still more handouts; these freeloaders want others to pay for their sloth. “Soak the rich,” they cry, for the rich allegedly have no right to the wealth they’ve actually earned, but the freeloaders supposedly have a “right” to the wealth they didn’t earn. The result is the false fiscal choice of hedonistic Keynesian “stimulus” schemes versus ascetic Puritanical “austerity” schemes; the former is a rationalization for still more government spending, while the latter is a rationalization for still more taxation. Instead, nations should adopt pro-capitalist, supply-side policies: viz., less government spending and taxing. Only that policy mix is consonant with the selfish enjoyment of our rights and the pursuit of our happiness.

As fiscal policy, government “stimulus” schemes have a good reputation, but undeservedly so. Invariably they only undermine and delay recoveries. “The economy,” remember, is what remains today of our private system of production; it can’t be “stimulated” by government taking more of its precious resources (savings) through borrowing, and then spending the proceeds on those who don’t work (i.e., don’t produce wealth) or on those who exhibit a greater “propensity to consume” (i.e., to destroy wealth). In contrast, fiscal “austerity” plans tend to have a bad reputation, but also undeservedly. Invariably such plans entail additional taxation of the private sector but no real restraints on government spending. Austerity programs, in truth, are perfectly compatible with renewed prosperity, if by “austerity” is meant not additional tax burdens laid on a struggling, ailing economy but material reductions in the size, scope and cost of government.

According to Keynesian Paul Krugman, austerity plans are “self-defeating.”As he puts it, “there’s quite a good case to be made that austerity in the face of a depressed economy is, literally, a false economy – that it actually makes long-run budget problems worse.” Well, “yes,” if austerity means more taxes imposed on the economy’s producers, but “no,” if instead it means spending cuts imposed on the economy’s non-producers (politicians). Krugman denies this, because he opposes reductions in government spending, and wants higher taxes on the rich, even in today’s context, a context he describes as a “depression,” and which, he adds, has been caused not by vast stimulus spending, to date, but by too little of it. In the 1990s it was Krugman who most loudly championed Japan’s innumerable and reckless “stimulus” schemes, together with dozens of rounds of “quantitative easing” (fiat money printing). Japan followed his advice and ever since then has suffered a secular stagnation. Since 1990 Japan’s public debt has ballooned from 68% to 233% of GDP; its money supply is up 286%, while its industrial output is lower by 3.4% and its equity index is down by 73%. This is what Keynesians “stimulus” has done for Japan – and Krugman wants the same for the U.S.

Mr. Krugman repeatedly invokes the magic multiplier, the bogus claim that when we spend our own dollar we boost GDP by a dollar, but when the government takes it and spends it, GDP is boosted by $1.40. Wow. Fabulous. Government spending not only “pays for itself,” but more than pays for itself. On this view, were government to take everything we earned and spend it, the economy might well expand to the moon. Is it magic – or voodoo? Krugman used to ridicule supply-side economists from the 1980s for saying tax cuts “pay for themselves,” even though no supply-sider ever actually said that, but for decades he’s been pushing this myth that government spending more than pays for itself. Who’s really practicing voodoo here?

Given decades of Keynesian myth-telling, most people today still believe that if economic recoveries are weak it’s because of too little government spending. “What’s hurting the recovery,” Krugman said recently, is “cutbacks at the public sector” level. The Nobel Prize winner calls a 24% increase in federal spending a “cutback.” Huh? Was he citing state and local spending? That’s up 9% since 2008. Dubious math skills aside, Krugman’s undying belief in the ole’ magic multiplier of government spending makes him insist that the world economy would benefit from what he fantasizes to be a government spending spree to repel space aliens. As he told CNN last summer, “If we discovered that space aliens were planning to attack and we needed a massive buildup to counter the space alien threat, and inflation and budget deficits took secondary place to that, this slump would be over in eighteen months. And then if we discovered, oops, we made a mistake, there aren’t actually any aliens, we’d be better off.” This is what passes for “economic science” today: sheer quackery, posing as profundity. In the same voodoo vein, Krugman’s idol, Keynes, wrote in 1936 that only the biases of free-market economists prevented the world from grasping the plain truth that prosperity can be fostered by “pyramid-building, earthquakes, even wars.” Krugman agreed with George W. Bush only once, in 2008, when the president, echoing Keynes, insisted the Iraq war would boost GDP.

On such views, how could any economy possibly grow when government spending crawls? Stimulus-loving Keynesians can’t even imagine that, while austerity-loving Austrians deny it can ever happen, even when it does. Consider America’s “Roaring Twenties” (1924-1929), when federal spending increased by only 8%. In contrast, during the worst years of the Great Depression (1930-1934) federal spending jumped by an astounding 100%. Which spending increase involved greater “stimulus?” Keynesians can’t explain the 1920s, while Austrians insist it was mere inflationary fluff (even though CPI declined from 1924 to 1929). As for the 1930s, Keynesians say spending was insufficient; so if the 100% rise didn’t work, a 200% rise might have?

More recently, consider the “stimulus” schemes of Bush–Obama (2008-2012), when U.S. federal spending increased by “only” 25%. In a prior column I explained why these failed miserably and precluded a robust recovery. Krugman complains that the 25% rise was too modest; he wanted a much bigger increase, perhaps double (+50%), or even +100% (the magnitude that deepened and prolonged the Great Depression). Next consider the vast reduction in U.S. federal spending that occurred amid the de-mobilization after World War I; federal spending was slashed 84% from 1919 to 1924, and during that time GDP increased 19%. After World War II spending was cut by 67% in just three years,(from 1945 to 1948, and Keynesians at the time were convinced, based on their bogus magic multiplier, that the private sector economy would unavoidably suffer from such a huge cutback; instead, real GDP grew by 13% in three years (1947-1950), and then accelerated, rising by 22% between 1949 and 1952. Going even further back, after the Civil War, U.S. federal spending was reduced by 79% between 1865 and 1872, and yet real GDP grew by 21% in that time. If the Keynesian “multiplier” myth was even close to the truth, such cuts would have ruined the economy.

Did the GDP booms I’ve cited merely reflect the uniqueness of post-war demobilizations? Recall it’s the Keynesians, not I, who insist war outlays “stimulate” growth while post-war cuts hurt it. They’re wrong. Even peacetime spending restraint has been bullish for growth. I’ve studied every 3-year peace-time period since the U.S. founding in 1790, and in cases when federal spending declined, real GDP over the same years grew by 11%, on average, not materially different from the average growth rate recorded in periods of rising spending. Government spending cuts have not been bearish for growth. From 1840 to 1843 U.S. federal spending was cut by 51% while real GDP grew by 11%; from 1866 to 1896 spending declined 38% as GDP grew by 9%; from 1874 to 1877 spending fell 20% as GDP advanced by 9%; from 1899 to 1902 spending dropped by 20%, but GDP rose by 13%; finally, between 1921 and 1924 spending decreased 43%, yet GDP climbed by 23%. No 3-year spending cut has occurred since 1949, and since then, GDP growth has slowed.

Let’s leave the Keynesians’ magic kingdom and Mr. Krugman’s fantasy world and enter the world of honest scientific analysis. Many careful studies have been conducted to try and discern whether economies globally (and fiscal balances) have improved or deteriorated in response to “stimulus” and “austerity” programs. Of course, many researchers who still cling to the myth of a magical Keynesian multiplier still define “stimulus” as increases in government deficit-spending, and define “austerity” as less government spending. Missing as an option is the policy mix that we truly need: less government spending and less taxation. But if there’s no government spending multiplier, and if government spending for reasons beyond those absolutely necessary to protect rights (defense, police, courts) only hurts the economy, then excessive government spending will be bearish for growth, and less of it bullish. Likewise, lesser taxation will be bullish for the economy.

This is precisely what a growing number of studies have shown. The first was by MIT’s Olivier Blanchard, in 1990. Perhaps the most revealing, a 2009 study by Alberto Alesina (Harvard) and Silvia Ardagna (Merrill Lynch), focused properly on the composition of fiscal programs. Typically such programs are defined by their total effect on budget deficits, not on how that number arises. Alesina and Ardagna instead examined the composition of “stimulus” and “austerity” programs – both the spending and the tax sides – in 21 developed countries between 1970 and 2007. They found that stimulus programs boosted economic growth if they consisted predominantly of tax cuts, but not if they consisted mainly of government spending increases. As for austerity programs, which seek to reduce budget deficits and public debts, Alesina and Ardagna found that they were more likely to succeed if they were based on spending cuts, but not if based on tax increases; also, austerity plans comprised mostly of spending cuts, not tax hikes, were less likely to trigger recessions. Even IMF economists, who tend to be Keynesian, corroborate such findings, for G-7 nations since 1976, in the recent volume, Chipping Away at Public Debt: Sources of Failure and Keys to Success in Fiscal Adjustment (2011).

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